According to one legend, when Achilles was born it was foretold that he would be killed in battle by an arrow. So, in an understandable pre-emptive move against that fate, his mother took him to the river Styx which could confer powers of invincibility. She dipped the infant into the river but, fatefully, held him by the heel, thus leaving this part of his anatomy untouched by the magical river’s water.

Australia’s big banks might be likened to the legendary warrior; surviving, as they have, the Global Financial Crisis—an upheaval of mythic proportions. But they’ve retained their Achilles’ heel and, in this article, we’ll explain where it resides.

Our banks might seem invulnerable given the government’s extraordinary actions throughout the crisis; guaranteeing deposits, underwriting bond issues and even proposing the creation of a $4bn Australian Business Investment partnership to help support liquidity in the commercial property market (an area prone to bad debts in savage downturns).

Key Points

Australian banks are the envy of the world, having retained their credit ratings

Our big banks’ loan-to-deposit ratios exceed 100%

A dependence on foreign lending exposes them to several risks

To draw the irresistible analogy, the Australian government’s moves were akin to dipping the big banks in the river Styx. And it worked, with the banks retaining their AA credit ratings as other institutions around the globe were downgraded.

Crucial role

Banks fulfil a crucial role in modern society. To use the academic vernacular, banks borrow money from ‘surplus economic units’ and lend it to ‘deficit economic units’, which is all lovely in theory. And it usually works in practice, too.

Take the recently floated Agricultural Bank of China (in which Seven Group has applied to invest US$250m). In 2008 – the most recent annual report we could find on its English language website – the bank showed a loan-to-deposit ratio of around 50%, meaning its loans were funded twice over by its deposits (a result of China’s many ‘surplus economic units’).

Agricultural Bank of China is a rather extreme case. But we’ve lined up the latest available figures from Australia’s big four banks alongside it and Warren Buffett’s biggest bank holding, Wells Fargo, in Table 1.

Table 1: Comparison of loans and deposits

Ag. Bank of China (RMB m)

Wells Fargo (US$m)

ANZ ($m)

CBA ($m)

NAB ($m)

WBC ($m)

Loans

3,014,984

758,254

335,352

482,019

427,488

474,644

Deposits

6,097,428

824,018

301,757

370,167

324,912

335,313

Loan/Dep.

49.4%

92.0%

111.1%

130.2%

131.6%

141.6%

It’s clear that the Australian banks are in a very different position. Each of the big four has a loan-to-deposit ratio of more than 100%. So how did we end up here, with our banks lending out far more than they carry in deposits?

Boom, boom, boom

Chart 1 illustrates the remarkable credit boom Australia experienced following the early 1990s recession. This explosion in lending far outpaced the growth in Australian deposits, which meant our banks had to fill the gap somehow. To do so, they turned to the international money markets and became dependent on the kindness of foreign lenders.

‘Australian banks source a significant share of their funding for domestic lending from offshore debt markets,’ the Reserve Bank of Australia (RBA) explained in its March 2010 Financial Stability Review, ‘mainly in the United States’.

The RBA’s figures show that as at March 2009 ‘around 20% of banks’ total liabilities were denominated in foreign currencies.’ This percentage has remained relatively stable over time, but the raw numbers involved ballooned through the credit boom. You can see the increase in the amount of foreign debt owed by the banks between 2005 and 2009 in Table 2.
If the banks simply borrowed foreign funds in the international money markets without doing anything else, then they’d have direct exposure to the notoriously fickle Australian dollar exchange rate. Their profits would be violently thrown around (soaring when the currency rises and plunging when the Australian dollar dives).

Yet the banks have produced a string of comparatively smooth profits, at least until the past couple of years. The RBA explains; ‘Despite this apparent on-balance sheet currency mismatch, the long-standing practice of swapping the associated foreign currency risk back into local currency terms ensures that fluctuations in the Australian dollar have little effect on domestic banks’ balance sheets.’

Derivative contracts

The trick involves the banks entering into hundreds of billions of dollars worth of derivative contracts known as ‘swaps’. These contracts involve an agreement to exchange interest rate and/or currency exposures for a set period of time.

Using such contracts, Australia’s banks can arrange a schedule of payments with another party that match off against their foreign currency-denominated debt. In this way, the banks know their exposure from day one.

Any gains or losses that arise on the loan due to currency movements are offset by an opposite result on the swap contract. That’s how a financial hedge is supposed to function and these contracts have worked nicely for our banks over the years.

Yet one of the expensive lessons taught so savagely by the crisis to financial institutions around the world is that arrangements that have worked smoothly in the past may not always do so in the future.

That lesson brought the businesses models of lenders dependent on securitisation to a screaming halt in 2007, when previously deep and liquid markets simply seized up. And at some point in the future, it might just pay Australian bank shareholders to have spent a few minutes today considering the risks they’re exposed to as a result of our banks’ reliance on offshore borrowings.

What’s the risk?

We suspect that few people fully understand how dependent our banks are on foreign debt and the mechanism by which they mitigate their exposure (through a series of swap contracts designed to insulate against currency and interest rate movements). And that brings us to the key issue.

Should future convulsions in the global financial markets send any of the institutions on the other side of these contracts to the wall, our banks would become more exposed to the harsh winds of the international financial markets. This is the nature of ‘counterparty risk’, a concept former customers of HIH Insurance came face to face with when that institution couldn’t make good on its financial contracts.

And if the past few years are any indication, the Australian dollar tends to fall in times of uncertainty. So the very conditions which might bring about the failure of the banks’ counterparties would be highly likely to coincide with a plunging Australian dollar; thus blowing out the repayments of foreign currency-denominated debts in local terms.

This is the nightmare scenario and, we reiterate, highly unlikely to occur. But it’s worth underlining the crucial gap between ‘highly unlikely’ and ‘impossible’.

It was highly unlikely that the seemingly invulnerable Achilles—the greatest warrior of Homer’s Iliad—would be felled. But eventually his weak spot was exposed. All Australians, and especially bank shareholders, must hope that our venerable financial warriors, who’ve survived so much in the past, will never have their own Achilles’ heel fully tested.

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